November 1997

Europe May Compromise

The European Union’s chief negotiator, Jorgen Henningsen, has conceded that the EU may be willing soften its stance on climate change. “It will be unrealistic to believe that we can strike a compromise with others if we just sit on a high horse, insisting on 15 percent, nothing but 15 percent,” said Henningsen. He expressed confidence that the EU and the U.S. would be able to narrow the gap between their respective positions. “The way to narrow the gap is for both parties to show a readiness to move.” “I have reason to believe that the Americans are ready to move. That is definitely the conditions on which we will move” (The Daily Yomiuri, November 11, 1997).

The U.S. Has Compromised

The United States delegation has conceded at an unofficial ministerial meeting that it will sign a protocol that calls for developing countries to reduce emissions in the future. The concession has allowed the developed countries to agree not to bind the developing countries with new obligations in the treaty to be negotiated in Kyoto. The concession makes almost certain a rejection of the treaty by the U.S. Senate (The Daily Yomiuri, November 9, 1997).

Administration Gag Order

U.S. undersecretary of state Timothy Wirth “outraged” Republican leaders by telling them that “they should keep their mouths shut and not criticize” the administrations global-warming stance at the climate change conference in Kyoto. A State Department spokesman said the instructions were “not unusual” and were meant to “ensure the United States speaks with ‘one voice’.”

Recall that then-Senators Timothy Wirth and Al Gore harshly criticized President Bush at the Earth Summit at Rio de Janeiro. Wirth accused Bush of “adolescent politics” and looking “silly” and “embarrassing” for not signing the treaty on biodiversity. Of course Wirth and Gore went as observers. Those congressmen who will be attending the Kyoto conference were given delegate status, a move many believe is the administration’s way to silence critics (Washington Times, November 11, 1997).

Worldwide Poll on Climate Change

Environics International Ltd., has conducted a poll which surveyed 27,000 people in 24 countries. The poll found majority support for concerted action on climate change in 15 of the 24 countries. Among industrialized countries the U.S. was the most skeptical with 46 percent wanting to “assume the worst and take major action now to reduce human impacts on climate,” and 46 percent saying we “should not take major action to reduce human impacts on climate until we know more, because of the great economic costs involved.”

Support for immediate action was strongest in France (74 percent), Germany (71 percent), Italy (71 percent), Switzerland (70 percent), Japan (69 percent), Australia (67 percent), New Zealand (65 percent) and Canada (61 percent). The poll suggests that concern for the environment is very strong in the industrialized countries and is growing in the developing countries (Calgary Herald, November 10, 1997).

Business Poll

A poll commissioned by the Confederation of British Industry has found that 83 percent its members are in favor of the EU’s proposal of a 15 percent reduction in greenhouse gas emissions below 1990 levels by 2010. Sixty-two percent of CBI members “believe Europe should unilaterally pursue an ambitious target even if it is not endorsed by other industrialized nations.”

Derek Norman, environmental manager of Pilkington, the glass manufacturer, doesn’t put much stock in the poll numbers. He believes that “There are a lot of businesses which . . . think nothing will happen at Kyoto so they won’t have to do anything,” making it easy to pay lip service to emission reductions (Financial Times (London), November 11, 1997).

Introduction

Since President Clinton announced in his speech at the National Geographic Society in Washington on October 23, 1997, among other measures to reduce CO2 emissions, the implementation of a national, as well as an international tradable permit system, it is important to take a closer look at emissions permits trading systems. The goal is to see if the concept of a trading system for emissions permits is a and workable solution to reduce so-called greenhouse gases emissions. This paper, however, shall not develop the argument for or against the need for government intervention to reduce the emissions of CO2 and other greenhouse gases, or even if there is a need to curb the emissions at all. The following arguments shall instead focus more on the problems of practical implementation and pose some questions that have not been discussed widely in the public arena.

For several reasons emissions trading systems are increasingly gaining political support. For one, the costs of an emissions permit trading system are not clear to consumers and often more difficult to calculate for companies. Consumers might not see the costs of a trading system as clearly as if they were confronted by a tax. Nevertheless the costs would most likely be passed on to consumers through higher prices. Companies have problems in calculating the additional costs from a trading system, since the price of permits in the future and the efficiency losses due to new regulations are often hard to quantify. The association of trading systems with markets – they are often called market-oriented instruments – makes them popular with to decision makers, who give the impression in the public that an emissions trading scheme is an economically efficient solution with little costs involved.

Another reason why trading systems are often preferred to a tax system is that with a tax system the government cannot guarantee a specific emissions level — it would need to find out what amount of tax is necessary to achieve a specific emissions level. A tax which is too high could lead to unnecessary costs for the economy, while a tax too low would not achieve the intended emissions reduction goal.

The following discussion shall assess at how much the market is really involved and how much command-and-control policy ⁽¹⁾ would still prevail in an emissions permit trading system.

Principal Idea of Emissions Trading Programs

Emission permits systems are often described as quantity instruments (determining the quantity of emissions) in contrast to emission taxes, which are characterized as price instruments (determining the price of emissions).

At the start of every emission permits trading program, governments would need to decide on the level of emissions they would be willing to accept. Administrative bureaucracies or international environmental agreements would set the standard of environmental quality that would have to be achieved (the same procedure as under a command-and-control policy). The market would not be involved in the decision as to which amount of emissions would be ‘optimal’.⁽²⁾

In a second step, governments would issue emission permits -for free or by selling or auctioning them off- that would not exceed the set emissions target. At that point companies would be allowed to trade these permits. Companies that could achieve a lower emissions level would be able to sell their unused permits to companies that would exceed their allowed emissions limit. The total emissions by all companies together would therefore not be higher than the set limit. Companies would not be forced into specific technologies; they could choose how and where to abate. The expectation would be that with this flexibility companies could achieve the pre-set emissions level with lower costs than under a command-and-control policy. Companies with low abatement costs would reduce their emissions and could sell their permits to companies for which it would be less costly to buy permits than to reduce emissions themselves. The abatement of emissions would therefore be achieved with a minimum of costs.

The question is, are tradable permit schemes therefore the ‘perfect’ solution to the cost problem?

The cases of practical application of these instruments are still rare, especially in connection with international environmental problems. In the following discussion, three forms of emission trading that were proposed for possible implementation to reduce greenhouse gas emissions shall be analyzed, compared and possible problems in their implementation will be highlighted. The discussion includes a review of perhaps the most prominent example of tradable emission allowances, the SO2 trading system in the U.S., following the Clean Air Act of 1990, and the implications of this program for other projects.

Three different proposals for tradable emission permits schemes

The three different schemes that shall be discussed are:

An international trading system: It would give each country a certain amount of permits for emissions that governments then pass on to domestic companies. The companies could then trade these permits with each other on a global basis.

A national permit system (plus fees): Is referring to a proposal by McKibbin/Wilcoxen⁽³⁾ of a system of national permits plus fees. Permits would be given out for free up to an agreed emissions target (for example, the 1990 level). Emissions above this level would be allowed, but companies would have to pay to their national governments a certain fee (for example $10) for each additional ton of emissions. Permits could only be traded nationally.

A tradable budget system: Each country would be given a specific emission budget, and parts of the budget could be traded with other countries or banked for later years. It might also be possible to borrow from future budgets. Several variations of this scheme are discussed.

All three schemes would lead to trading in one form or another, but the national permit system would not be able to guarantee that a specific emissions level would be achieved, since companies would be allowed to emit CO2 beyond their acquired permits. Companies would nevertheless have an incentive to abate emissions if the abatement costs are less than the fees they would have to pay for additional tons of CO2.⁽⁴⁾

Distribution among countries

For all systems the first obstacle for reaching an agreement would be the amount of emissions granted to each country. Numerous proposals are on the table for the upcoming Conference on Climate Change in Kyoto, such as allocation according to the countries’ 1990 emission levels (or minus 5 percent or more). Some countries demand that other benchmarks be included, such as projected population growth, energy usage per GDP, state of the economy and more, to reflect the diverse socio-economic situations of the negotiating countries. Finding common ground on this issue will probably be the biggest impediment to reaching an agreement in Kyoto.

The decision on emissions targets goes to the very heart of the national interest of each country, because it involves issues of national sovereignty, national security,⁽⁵⁾ economic growth and its potential for future development. The amount of emissions, and therefore permits, allocated to each country will have a decisive economic impact. The initial allocation could lead to large transfers of wealth between countries. The possible significant inflows and outflows of money could thereby determine who would be the ‘winners and losers’ of such a system. For example, Russia and other East European countries might be able to sell huge amounts of permits, because of their shrinking economies during the last several years and newly imported technology which emits less CO2 than their old technology. This could mean large transfers of wealth from countries such as the U.S. to Eastern Europe, because the U.S. and others might need to buy emissions permits due to their expanding economies.

Since the decision on emission levels might lead to a cap on energy use, it is important in the negotiations for every country to achieve a level of allowed emissions that does not destroy its potential for future economic growth. It should not be underestimated that some of these negotiations will be a pure fight for market shares, where the environmental issue will be pushed into the background. Countries and industries will try to protect their self-interest, which in part means not giving any additional advantage to their potential competitors.

Domestic distribution

After the decision has been made about the level of emissions, the next step is to decide how the permits or allowances should be allocated among companies. Initially it must be established which companies should be involved in the trading scheme. The inclusion of primary energy producers and primary energy importers would seem to be a more practical way rather than including all companies that emit CO2 or even individual households. Although it seems impossible to include consumers in a permit system, it appears the idea is not totally dismissed, at least in theoretical discussions in the Administration, according to a report of the Electricity Daily, November 14, 1997.⁽⁶⁾

Since the number of companies that emit CO2 would be extremely high -not to mention the number of households, their inclusion would make monitoring impossible. Also energy rationing seems not a particular popular with voters in industrial countries and elsewhere.

If the goal of the trading system is protecting the earth from the potential danger of global warming, the trading system should not concentrate on CO2 emissions alone. The investment in different forms of “protection” should be recognized, for example, investing in CO2 sinks should be as much rewarded as investment in CO2 abatement technology.⁽⁷⁾

The reduction of other greenhouse gases, such as methane and nitrous oxide -with higher heat trapping effects than CO2- should also receive credit. These measures would make a trading system even more complicated, but those promoting a trading system should consider these points, otherwise a trading system is not really reaching the proclaimed goal of preventing global warming.

Options for issuing emissions permits include auctions, sales, or distribution for free; among these options, numerous variations exist. Auctions and selling would bring governments additional revenues.⁽⁸⁾

On the other hand, companies would face higher costs, and if not enough permits are available, they would also face the uncertainty of receiving enough permits to continue their production. For these reasons the so-called “grand-fathering” of permits is often preferred, that is, existing companies would receive permits according to their actual or past emissions for free. This approach would give firms with large amounts of emissions a potential advantage and could be regarded as discriminating against companies that had already reduced their emissions much earlier. It also may operate as a barrier to entry as new companies would have to face the additional cost of buying emissions permits while their competitors, already in the market, received their permits for free.

The way in which auctions are organized could influence the price and allocation of the permit.⁽⁹⁾

The SO2 allowance trading in the U.S., for example, has shown that the chosen auction procedure has influenced the price, and it is mentioned as one of the reasons for lower than expected trading volume.⁽¹⁰⁾

The decision of how to distribute and auction the SO2 emission allowances was also influenced by political efforts to share the burden of the additional costs of the program. Otherwise, some states in which the costs would have been concentrated would have been particularly hard hit.⁽¹¹⁾

The initial allocation of permits could affect the equity as well as the efficiency of the market. The allocation, for example, might result in dominance by some companies.⁽¹²⁾

Some authors suggest that imperfect competition in input, as well as in the output markets can reduce the welfare of the trading.⁽¹³⁾

The described procedures for distribution could be used in all three forms of a trading system. However, in the case of a tradable budget system, how or if permits would be distributed is not clear. The government could introduce some sort of trading inside the country or try to achieve the allowed budget by a command-and-control policy regime.⁽¹⁴⁾

In the case of national emissions permits trading the concept is to give out the permits to the companies up to the agreed level (for example, 1990 emissions level) for free to save costs for companies.

Validity, Property Rights and Taxes

The validity of the emissions permits would have to be determined and clear property rights for the permits would have to be established if a trading system were to be successful. For example:

What would happen if the government decided to reduce the amount of allowed emissions further?

Would permits be made invalid or would the government have the legal obligation to buy them back from the companies and, if so, at what price?

Would the government hold auctions only once or would companies have to renew the permits after a certain time?

These open issues need to be decided before companies could regard permits as property rights. Only if property rights are established could companies regard emissions permits as an asset.⁽¹⁵⁾

These points also need clarification to establish how these permits should be handled in regard to taxation, e.g. taxation of gains through trading of permits.

The government could hold back parts of the initial amount of permits for new companies to prevent additional market-entry barriers due to the costs for emissions permits. For companies it is critical to operate in a situation of “legal-certainty” and to face no uncertainties over drastic policy changes relating to the permits. Since investments are often planned with a multi-year horizon, companies need some legally binding assurances that they can continue to produce over a longer period of time.

Organization of the Markets

Another issue is how the markets themselves would be organized. All three trading schemes would lead to different market-forms.

An international trading scheme could be organized through a truly international market, where all companies affected by the agreement in all participating countries would participate. An efficient international market could probably only be organized through an international computer trading system. A computer trading system could insure the fast and easy access to the market for a large number of companies around the world. Even if the execution of the actual trading would be made easier through computer technology, there would remain several serious problems for an international market, for example:

Which authority would oversee an international emissions permit market?

In which currency would trades be made, and which trading rules and laws would apply (stock and currency markets around the world use different trading systems and regulations)?

In case of violations of trading rules, which procedure would be used to penalize such infringements of the agreements?

An international trading scheme could also be organized alongside the already existing national stock or currencies exchanges, with companies mostly trading on their national exchanges, and with bigger market players dealing on the global markets, thereby insuring that no or only smaller arbitrary gains occur. Problems would arise if companies had to go to other national markets to buy permits. Different market rules would apply and differences in national laws could lead to complications in trading, similar to the problems companies face if they offer their shares on different national stock exchanges, with differing regulations and accounting forms and other currencies. The authority that would regulate the trading must be well established.

A national trading scheme plus fees would face fewer problems, because it would not have to deal with the national differences in laws and regulations. However, a national scheme would be difficult for countries where insufficient markets exist, especially in some of the emerging markets. Since the real differences in technology and abatement costs exist between the industrial and developing countries, the absence of international trading and especially the exclusion of developing countries would greatly reduce potential cost savings, from its maximal potential.

Governments would also have to decide on the right amount for the additional fee, because it would ultimately determine the upper price limit for the permits. If it is set too low companies might not restrict their emissions, and if the fee is set too high the additional costs of the trading system could hurt the economy.

For both national and international trading schemes, the creation of future markets for emission permits could play an important to ensure that companies could hedge their risks and allocate their abatement policy in the most cost-effective way over time. Since it might not be the most cost-effective way for all companies to abate at the same time and even for the economy as a whole, it could be preferable to postpone the reduction of greenhouse gases emissions without changing the effect on any imposed emissions target in the future.⁽¹⁶⁾

It would enable companies to take a more long-term approach to permit trading and assure them that a secondary emissions market exist in future time periods.

A system of tradable budgets would not necessarily mean that a market for emission permits would be created, since every country could probably choose how to achieve its budget target. Some countries might chose a national tradable emission permit scheme with potential opportunities and problems similar to those discussed for the national trading scheme. Other countries might decide to achieve the budget target through a rigorous regulation scheme or bilateral exchanges between countries. Trading between governments would not lead to an efficient market, as other aspects, such as political issues, could heavily influence the trading.

A sufficient number of participants in the market would be required for a functioning market. In an international permit trading system the number of participants would be large, since every affected company in participating countries would be eligible to participate. Even on a national level the number of companies affected by the regulation would be relatively large. The decision to trade permits in any market would depend on the costs for these transactions. If companies experience higher costs than potential benefits, and are confronted by complicated trading procedures, companies will not trade but will look to various forms of internal abatement, even if these measures are not the most cost efficient way for the companies to reduce their emissions.

The General Accounting Office report on the SO2 emission allowance trading identified the long implementation timetable of the emissions reduction as a cause of the thin volume of trading. Companies had several years to apply the reduction. The long time period resulted from the problem that the number of buyers and sellers rarely matched; there were usually more sellers than buyers in the market.⁽¹⁷⁾

Companies had enough time to look for other opportunities to reduce the emissions or had already invested in new abatement technology. That could be a problem if long implementation and phase-in times are negotiated for the CO2 emission reductions.

It also must be decided who would be allowed to participate in the market, for example:

Would environmental groups, other governments or interested private persons be able to participate?

Or would only the companies that are affected by the regulation be allowed to trade?

The market must insure that information about both prices and companies are easily accessible to all participants. The restriction of information to only a few companies or countries could lead to a distortion of the market process. This could be a problem especially for larger trading schemes, such as a global trading in emission permits, but also for national schemes, especially if a country lacks the technological infrastructure.

Market power

A market for permits nationally or internationally could be seriously undermined if some companies (or in the case of tradable budgets, some countries) hold enough permits to influence the market, such as influencing the price in their favor. This situation could lead to efficiency losses in the market. The efficiency losses are influenced by the initial distribution of the emissions permits.⁽¹⁸⁾

For a national trading scheme it would have to be guaranteed that foreign companies would have the same access to permits as domestic companies if they invest in other countries. The danger is that governments could try to prevent competitors of domestic companies from entering the market. A permits trading system should not restrict international investment by setting up barriers against the free flow of capital.

Monitoring

Perhaps the most important prerequisite for a functioning market of tradable permits would be the efficient monitoring of the observance of such a treaty. It seems extremely difficult to solve the monitoring problem, but it would be essential for all forms of permit trading or any form of agreement, because if the treaty is not strictly enforceable the price of permits would fall. No one would be willing to pay money for a permit if companies could violate the treaty and escape scot-free. Companies in countries strictly enforcing the agreement would face a significant disadvantage vis–vis companies in countries that do not.

How the monitoring could be achieved in practice is rarely discussed, especially if the scheme were to exist on a global basis. The surveillance of all sources of CO2 emissions (even if only primary energy producers or importers are affected) would require an enormous technological infrastructure and consequently financial resources. Not all countries would have the resources to do so, especially if developing countries would join such an agreement. Remote areas and the lack of technology to oversee the sources of CO2 emissions will make the problem for them even more difficult.⁽¹⁹⁾

Some have advocated that the UN, or an organization affiliated with it, might oversee such a treaty. Right now, the UN does not seem to have the manpower or the financial resources to achieve such a complicated task. The unwillingness by some countries even to pay their regular contributions shows how hard it would be to raise enough money for such a large assignment. Many countries might be reluctant to open up their industries for emission inspections by any international organization, fearing an encroachment on their national sovereignty.

On the other hand, many argue that the monitoring would have to be done by a neutral party, such as an international organization, otherwise there would be an incentive to manipulate the data. Domestic controllers might be more reluctant to report violations by domestic companies because it would hurt the local economy. Even official statistics can be arranged to fit into certain political concepts (for example, see how European countries are struggling to meet the Maastrich criteria), so one can only imagine what might happen on a local basis if domestic companies are involved.

A national permit system would avoid some of the problems of an international trading system. The national governments would have more incentives to monitor emissions, because the additional fees would be paid to the national authorities and could be added to the national budget.⁽²⁰⁾

Enforcement

While monitoring would be difficult, perhaps even more controversial would be the enforcement of a treaty of emissions restrictions. Enforcement through trade sanctions and embargoes seems an inappropriate way to deal with the issue, since such threats would only hamper negotiations and might disrupt international trade. Smaller and developing countries might feel pushed into a treaty by their lack of economic and political power, since they are usually more vulnerable to trade sanctions than larger countries.

Macroeconomic Effects

Another problem, not yet fully investigated by economists, which is also strongly related to the initial distribution of allowed emission targets for every country, is the macroeconomic effects of an international tradable emissions permits on international financial systems, exchange rates, and international trade itself. Some authors have raised the question of what would happen if emissions were reduced to and frozen at the 1990 level. The scenario could be that countries, such as the U.S., would be forced to buy large amounts of permits from countries in Eastern Europe, such as Russia, which might be able to sell permits because of its shrinking economy in the past several years. This could lead to huge transfers of wealth from the U.S. or other industrialized countries to Eastern Europe. These countries would therefore be rewarded for having run inefficient and polluting industries in the preceding decades. This problem exists for all forms of uniform emissions targets, but in the case of emissions trading these countries face an even greater advantage over countries that increased their abatement efforts earlier, because they now also receive a financial reward for their behavior. This transfer might be very helpful for these countries or for developing countries if they decide to join, but the political acceptance in industrial countries seems questionable.

This international system might not even amount to much reduction of emissions, since some countries, in particular Britain, Germany and Russia, have already reduced their emissions from the 1990 levels.⁽²¹⁾

These countries would be able to sell their unused permits to countries that might not be able to achieve the emissions target. In this case the system would not lead to much emissions reduction overall; it would only transfer money from one country to another because of the unbalanced allocation of the emissions between these countries.⁽²²⁾

There could be a significant influence on the trade patterns of participating and non-participating countries. These structures would also determine which countries would be better off with different forms of emissions reduction scenarios. Depending on the types of products a country produces (energy intensive production or not), the export pattern and on the goods and resources it has to import, even countries that do not participate in the permit trading themselves might be hard hit if their potential trading partners can no longer afford some of the products or if the prices of resources and products they have to import rise dramatically.⁽²³⁾

Since competition on a global basis is becoming more intense, a country might base its decision for one system or another on the impact it will have on its biggest competitors.⁽²⁴⁾

The in- and outflow of permits could also affect exchange rates. Large permit purchases by industrial countries from developing countries could lead to appreciation of their currencies, which would hamper other exports so that the overall effect on the economy would be negative.⁽²⁵⁾

It could change trade balances, for example, the U.S. trade deficit might grow if the U.S. would be forced to buy emission permits from other countries. There might be an influence on inflation rates and on national budgets. How emissions trading systems would influence these areas is still very unclear and requires more research.

Influence on Technical Progress

Advocates of emissions taxes fear that a tradable emissions permits system could lead to a slow down in the development of abatement technology because a company would have fewer incentives to develop new technology than under a tax system. The company could reduce its own emissions and possibly sell unused permits to other companies, but the new technology could also lead to a potential loss in the value of permits, because demand for permits would fall and consequently the price for permits would drop. This could mean, in theory, a bigger loss for the company than the potential gain from selling permits. A tax, in contrast, would always give companies an incentive to abate more if the costs for abating an additional ton of emissions is less than the tax for the ton of emissions.⁽²⁶⁾

How much influence this has on R&D by companies is hard to estimate, but it could be a potential problem for trading schemes as it is for command-and-control policy where the same problem exists. In command-and-control policy regimes the companies are often forced to adapt “the best technology available.” This rule gives companies little incentive to develop new and cleaner technology, because it might lead to stricter environmental standards, which could involve huge costs for companies.

SO2 Allowance Trading

The sulfur emission allowance trading is often used in public discussions as an example of the successful implementation of an emissions allowance trading scheme.

While supporters of such schemes point out that the trading in sulfur allowances has led to considerable savings for the affected utilities, since the price for the allowances is much lower than originally projected, skeptics point to the impact of deregulation and other influences which led to lower prices. In the following discussion, the main results of the trading scheme so far shall be summarized and the possible transferability of the experiences with the trading of SO2 emissions allowances to the planned CO2 schemes will be discussed.

Background of the SO2 Trading

Title IV of the Clean Air Act Amendments of 1990 ordered a sharp reduction of SO2 emissions that were thought to be responsible for acid rain. The U.S. Environmental Protection Agency (EPA) used a new approach departing from the usual regulatory policy. In phase I, which went into effect in 1995, the 110 electric utilities with the most emissions had to reduce their SO2 emissions. Annual allowances were given out free to these utility companies; they could than transfer them and even bank them for the future. The companies were able to choose where they would make the reduction of emissions.⁽²⁷⁾

The EPA distributed the allowances based on fossil-fuel usage in the mid-1980s. Later, the electric utilities were allowed to sell to or buy permits from other utilities or use them to cover excess pollution in other plants of the same utility company where it would exceed the allowed emission level. In addition, since 1993 the EPA is auctioning about 2.8 percent of allowances annually, in order to help the establishment of the allowance market.⁽²⁸⁾

Before the Clean Air Act Amendments, the marginal costs of abatement for SO2 were estimated by the EPA to be up to $1500 per ton. The EPA expected the allowance price to range around half of the original marginal costs. These numbers were later corrected downwards; in 1995 the marginal price for allowances at the annual auction was between $122 to $140,⁽²⁹⁾ in 1996 it fell further to around $70.⁽³⁰⁾

The EPA’s approach to auctioning could have contributed to the lower than expected price. The price might have been lower than the actual marginal costs of abatement due to the process which encouraged offering allowances at a lower price. Trading outside of the official auction market reached higher prices.⁽³¹⁾

But not only the price for the allowances was surprisingly low but also the number of trades was below the estimated level; only 2.3 million allowances were traded in 1995 (excluding the annual auctions).⁽³²⁾

The lower price indicates that the costs for companies are less than feared and seems to suggest that the trading system is a total success. But several reasons may explain why the price is lower than expected, and not all are related to the trading system itself.

The switch by many utilities to low-sulfur coal (encouraged by the big price drop for this coal).⁽³³⁾

Railroad deregulation, which resulted in a sharp drop in shipping prices that makes shipping low-sulfur coal from the West of the U.S. to the rest of the country more attractive.⁽³⁴⁾

Distribution of additional allowances above the original distribution.⁽³⁵⁾

Irreversible investment in abatement techniques, which have reduced the demand for allowances by high-cost abaters.⁽³⁶⁾

Stiffer competition in coal, natural gas and scrubber industry.⁽³⁷⁾

Most of the reduction and savings it seems were achieved by intra-utility transfers, meaning that companies arranged the abatement inside the company in those plants with lower costs of abating, rather than trading allowances with other utilities.

The low trading is also the result of some regulations by the state public utility commissions (PUCs) in areas such as allowed rate of return, depreciation rate, and the restriction on how much of the expenses are passed on to the rate-payer. These rules can affect the incentive to trade allowances instead of other ways to cut emissions. There is also still no decision on how cost recovery is going to be regulated.⁽³⁸⁾

Certain areas tried to protect their local coal suppliers by giving incentives to companies to use local coal instead of buying somewhere else (many state laws do not allow the undermining of local economic activity).⁽³⁹⁾

Many of the potential buyers of allowances, (most of them estimated to be the smaller plants with higher costs of abatements), do not have to reduce their emissions before the next phase of the program in the year 2000. Therefore these plants have more time to reduce their emissions without the need to buy allowances from the larger utilities. This leaves the allowance market with smaller numbers of traders willing to sell and especially to buy. As a result the market remains thin, which makes predictions about the price more difficult.⁽⁴⁰⁾

But the number of trades seems to increase and will probably play a bigger part in the future strategy of utilities, especially with increasing competition due to further deregulation of the electricity market.

The EPA rules at its annual auction, which includes two auctions, one a spot auction for allowances for the current year, and an advanced auction for allowances which can be used in seven years, are potentially influencing the price of the allowances and lead to a less efficient trading system.⁽⁴¹⁾

Lessons for other tradable allowance schemes?

The question is how far can the experiences of the sulfur scheme be translated to evaluate the trading proposals described earlier? There are fundamental differences between the SO2 trading scheme in the U.S. and possible CO2 trading schemes, which makes it difficult to compare the two approaches:

CO2 emission permit trading would cover more sources than the SO2 regulation. With the increasing numbers of sources, monitoring would become more complicated and costly.

The negative environmental effects of U.S. SO2 emissions are restricted to the U.S. territory and neighboring regions; in the case of CO2 emissions, the possible negative environmental impact would be felt world-wide.

The sulfur trading is organized under one national authority and jurisdiction, which allows for easier enforcement than would be in the case with an international trading system where enforcement is much more complicated, since it would have to be done under the supervision of an international authority.

The sulfur trading system has a well established working monitoring system, but such a system would probably be extremely difficult to establish in the case of an international CO2 system.

Conclusion

After reviewing three forms of emissions trading proposals, the question remains, are tradable emission programs the ‘magic’ way of reducing emissions at almost no costs, or much reduced costs?

The analysis has shown that the idea of tradable permits is an important tool in environmental policy. Its introduction has opened up the debate for more flexible approaches to environmental problems, away from the strict regulatory approaches in earlier years; but it has also shown where its restrictions and problems are. Trading systems have the potential to reduce the costs for companies in comparison to the old command-and-control policy approach, but to estimate how high such savings would be is difficult to estimate. Even reduced costs does not mean the restriction of CO2 emissions would be for free; higher energy prices for companies and consumers result in the reduction of economic activity. The trading systems would therefore perhaps mitigate the pain or at least people would not realize it as easily as if they were confronted by open energy taxes, but to reduce the use of energy -and therefore CO2 emissions- the price of energy needs to be raised. The illusion that somehow trading systems could avoid putting an additional price on energy use is wrong.

It is therefore important to point out that tradable emissions permit systems or tradable budgets do not solve the fundamental problems: Is the cap on emissions really needed or not and what level would be the ‘right’ one? Any emission trading scheme can only work inside this already set framework; thus these trading schemes are therefore not really market instruments.

The example of the SO2 trading showed lower costs than were initially expected by many, but how this could be translated to other programs is difficult to calculate and needs more analysis of the existing program, since other issues have played an important role in the cost savings achievement in this program.

The analysis has shown that there are serious difficulties involved in the implementation of trading schemes, especially if an international trading program is considered. Many of these issues have not been sufficiently discussed in public debate, except for theoretical analyses by economists. How these programs would be/could be organized in reality is a decisive factor in the analysis about whether these programs would be workable. The discussion should focus on whether these programs could really work on a larger scale. To draw wide-ranging conclusions from a limited number of much smaller programs than the proposed CO2 emissions trading is not sufficient evidence that an international trading system would work.

1. In a command-and-control policy regime, governments and agencies decide on definite emission limits as well as the ways how companies are allowed to achieve their emissions targets, companies are therefore often confined to certain technologies.

2. In the decision to determine the emissions target lies the essential problem of any trading system. The emissions level is not decided by the market, but by a national or an international authority that sets an emissions target that cannot be the optimal target for everyone. Some argue that the government or any international agreement will never be able to define the ‘optimal’ emissions level because the authorities do not have the information needed, and therefore the trading system leads to inefficiencies in the economy. Others dispute the idea of an “optimal” emissions level for the economy as a whole, insisting an “optimal” emissions level exists only for each individual depending on his or her preferences; as a result the government cannot and should not set emissions targets.

3. The proposal is outlined in Brookings Policy Brief No.17, “A Better Way to Slow Global Climate Change,” by Warwick J. McKibbin and Peter J. Wilcoxen, at: http://www.brookings.org/ES/POLICY/Polbrf17.htm.

4. Ibid., p. 6.

5. The military is in many countries a large emitter of CO2.

6. “Clinton Plans Permits to Ration Fossil Fuels,” in The Electricity Daily, November 14, 1997.

7. For example, Peter Hartley (1997), “Can international tradeable carbon dioxide emission quotas work?” The paper was presented at ‘Countdown to Kyoto’: The Consequences of the Mandatory Global Carbon Dioxide Emissions Reductions, Australian APEC Study Centre, Canberra, 19.-21. August 1997, p. 10.

8. The redistribution of these revenues could have a decisive effect on the welfare impact of the program. The money could be redistributed to the companies, used for cutting deficits, redistributed to groups that would be particularly hard hit by increasing energy prices, or allocated to other areas in the budget.

9. Timothy N. Cason (1995), “An Experimental Investigation of the Seller Incentives in the EPA’s Emission Trading Auction, in American Economic Review, Vol. 85, No.4, Sept. 1995, p. 905.

10. General Accounting Office (GAO) Report (1994), GA1.13: RCED-95-30, “Air Pollution: Allowance Trading Offers an Opportunity to Reduce Emissions at Less Cost,” pp. 53-55.

11. Karl Hausker (1992), “The Market for Sulfur Dioxide Pollution,” in Journal of Policy Analysis and Management, Vol. 11, No. 4, Fall 1992, pp. 566-569.

12. See, for theoretical debate, for example, Robert W. Hahn (1984), “Market Power and Transferable Property Rights,” in Quarterly Journal of Economics, Vol. XCIX, November 1984, No. 4, pp. 753-765, Hege Westkog (1996), “Market Power in a System of Tradeable CO2 Quotas,” The Energy Journal, Vol. 17, No. 3, 1996, pp. 85-103, and Stavins R. N. (1995), “Transaction Costs and Tradeable Permits,” Journal of Environmental Economics and Management, Vol. 29, pp. 133-148.

13. For example, David A. Malueg (1990), “Welfare Consequences of Emission Credit Trading Programs,” in Journal of Environmental Economics and Management, Vol. 18, 1990, pp. 66-77.

14. Unfortunately, the proposal of a budget trading system was introduced by the U.S. delegation in earlier meetings to prepare for the Conference on Climate Change but very few details have emerged on how such a system would be organized in practice, a problem that also exists for other proposals and hinders the analysis of the approaches.

15. Peter Hartley (1997), “Can international tradeable carbon dioxide emission quotas work?” The paper was presented at “Countdown to Kyoto”: The Consequences of the Mandatory Global Carbon Dioxide Emissions Reductions, Australian APEC Study Centre, Canberra, 19-21 August 1997, p.9.

16. Wigley, T.L., Richels, R. and Edmonds, J.A. (1996), “Economic and environmental choices in the stabilization of atmospheric CO2 concentrations,” in Nature, Vol. 379, 18. January 1996, p.p. 240-243.

17. GAO Report (1994), p.4.

18. See, for example, Robert W. Hahn (1984) “Market Power and Transferable Property Rights,” in Quarterly Journal of Economics, Vol. XCIX, November 1984, No. 4, pp. 753-765, and Hege Westkog (1996), “Market Power in a System of Tradeable CO2 Quotas,” in The Energy Journal, Vol.17, No.3, 1996, pp. 85-103.

19. The situation in the U.S. might be easier because some of the companies are already involved in the sulfur trading process. The technical equipment to monitor the SO2 emissions could also track CO2 emissions. GAO Report (1994), p.62.

20. Warwick J. McKibbin and Peter J. Wilcoxen (1997), “A Better Way to Slow Global Climate Change,” Brookings Policy Brief No. 17, p. 6.

21. These reductions were not necessarily connected to environmental reasons. Britain slashed its subsidies for its coal-mining industry, which led to a switch to the cleaner natural gas as fuel, while (East-)Germany and Russia experienced the closing of unprofitable -and often very dirty- plants under the new market regimes.

22. Warwick J. McKibbin and Peter J. Wilcoxen, (1997), “A Better Way to Slow Global Climate Change,” Brookings Policy Brief No. 17, p. 5.

23. For an extensive discussion of the impact on trading patterns see, Brown, S. et al. (1997), “The Economic Impact of International Climate Change Policy,” Australian Bureau of Agricultural and Resource Economics (ABARE) Research Report 97.4, Canberra.

24. Surprisingly the ABARE study shows in contrast to the offered suggestions, the U.S. might be better off if countries decide on uniform emission reduction, while the Europeans could profit more from a tradable emission permit system. See ABARE, “The Economic Impact of International Climate Change Policy,” p. 9.

25. Warwick J. McKibbin and Peter J. Wilcoxen “A Better Way to Slow Global Climate Change,” Brookings Policy Brief No. 17, p. 5.

26. Jean-Jacques Laffont and Jean Tirole (1994), “Environmental policy, compliance and innovation,” in European Economic Review, Vol. 38, 1994, p. 561. See also for the discussion on R&D, Ian Parry (1996), “The Choice Between Emissions Taxes and Tradable Permits When Technological Innovation is Endogenous,” Resources for the Future Discussion Paper 96-31, August 1996.

27. Phase II of the program will come into effect in the year 2000 and will include smaller utilities (greater than 25 mega watt) burning fossil fuels. It will also lower the average SO2 emission allowed for the utilities.

28. Dallas Burtraw (1996), “The SO2 Emissions Trading Program,” in Contemporary Economic Policy, Vol. XIV, April 1996, p. 82.

29. Ibid., p. 83.

30. Timothy N. Cason (1997), “Market Masked Regulation,” in Regulation, Summer 1997, p. 15

31. Ibid., p. 15.

32. Dallas Burtraw (1996), “The SO2 Emissions Trading Program,” in Contemporary Economic Policy, Vol. XIV, April 1996, p. 82.

33. Ibid., p. 85.

34. Ibid., p. 88.

35. Klaus Conrad and Robert E. Kohn (1996), “The US market for SO2 permits,” in Energy Policy, Vol. 24, No. 12, 1996, p.1051 and p. 1054.

36. Ibid., p. 1051.

37. GAO Report (1994), pp. 28-29.

38. Dallas Burtraw (1996) “The SO2 Emissions Trading Program,” in Contemporary Economic Policy, Vol. XIV, April 1996, p.82, and GAO Report (1994), p. 45.

39. J.J. Winebrake et. al. (1995), “Estimating the Impacts of Restrictions on Utility Participation in the SO2 Allowance Market,” in The Electricity Journal, Vol. 8, No. 4, pp. 50-54.

40. GAO Report (1994), p. 4.

41. Timothy N. Cason (1995), “An Experimental Investigation of the Seller Incentives in the EPA’s Emission Trading Auction,” American Economic Review, Vol. 85, No.4, September 1995, pp. 906-907.

U.S. Position Revealed

On October 22, after months of speculation, the Clinton Administration finally announced its official negotiating position for the upcoming climate change talks in Kyoto, Japan. Claiming that the “vast majority of the world’s climate scientists have concluded that if the countries of the world do not work together to cut the emission of greenhouse gases, then temperatures will rise and will disrupt the climate,” Clinton laid out a “comprehensive framework” that will include “three elements.”

First, the U.S. will commit to reducing emissions to 1990 levels between 2008 and 2012 and then work for further reductions. Second, the Administration will support “flexible mechanisms,” such as joint implementation and tradable emission schemes. Third, developing countries must also participate in “meeting the challenge of climate change.” Industrialized countries must lead, but developing countries must be “engaged.”

Clinton assured that “The United States will not assume binding obligations unless key developing nations meaningfully participate in this effort.” What is meant by “meaningful participation” is not clear. It is clear, however, that not all developing countries will be required to restrain their emissions.

Clinton also asserted that the U.S. cannot afford to “wait until the treaty is negotiated and ratified to act.” In other words, the Administration plans to implement climate policies before the Senate considers treaty ratification.

He further explained, “we must move forward by unleashing the full power of free markets and technological innovations to meet the challenge of climate change.” He plans to “unleash” free markets by:

• enacting tax cuts and investing $5 billion over the next five years in targeted subsidies for energy efficiency and the use of cleaner energy sources;
• encouraging companies to take early action by “giving them credit for showing the way;”
• creating a tradable permit or quota for reducing emissions drawing on the experience of acid rain permit trading;
• reducing energy use by the federal government through new technology, renewable energy resources and partnerships with private firms;
• unleashing competition in the electricity sector and removing outdated regulations, in a way that leads to even greater progress in cleaning our air and delivers a significant down payment in reducing greenhouse gas emissions;”
• encouraging corporations to prepare their own greenhouse gas reduction plans and having federal, state and local governments remove barriers to greater energy efficiency.

Clinton assures us that this will be quite painless. He claims that “the conversion of fuel to energy use is extremely inefficient and could be made much cleaner with existing technologies or those already on the horizon, in ways that will not weaken the economy but in fact will add to our strength in new businesses and new jobs. If we do this properly, we will not jeopardize our prosperity – we will increase it.” President Clinton’s speech can be found at www.whitehouse.gov/Initiatives/Climate/main.html.

Domestic Reactions to U.S. Proposal

There were many reactions from Capitol Hill. Sen. Frank Murkowski (R-Alaska) said, “To reach the president’s targets, we will need a $50 per ton carbon tax. American consumers and workers will pay dearly and, unless China, Mexico and the other developing countries follow suit, global emissions will still increase.”

Rep. John Dingell (D-Michigan), Chairman of the Senate Committee on Environment and Public Works, stated that, “Any agreement in Kyoto must do more than exact a vague promise from the developing countries to participate at some point in the future.” He further said, “The virtues of the president’s proposal – and there are a few – are problematic. There is no doubt about the need for new technologies and the promise of research. Voluntary measures and incentives are better than mandates.”

Rep. George Brown (D-California), Science Committee Ranking Democrat, said Clinton’s proposal is “a sound and reasonable beginning step.” The plan, argues Brown, will lead to “economic growth based on wise and efficient use of all energy resources.”

House Majority Whip Tome DeLay (R-Texas) said Clinton “has fully embraced the unproved theories of global warming while promoting damaging regulations and higher taxes that will come from the Kyoto conference. I think that is a real environmental disaster” (BNA Daily Environment Report, October 23, 1997).

Industry groups also criticized the proposal. Karen Kerrigan with the Small Business Survival Committee, a member of the The Global Climate Information Project, said, “The proposal still is not truly global” She contends that the developing countries must have “specific scheduled” commitments to reduce emissions. Gail McDonald , president of the Global Climate Coalition said, “It’s worth repeating that American families can expect to pay at least $2,000 a year by 2010 if these efforts to reduce energy are implemented.” Both the subsidies and the trading scheme that Clinton proposed “ultimately must be paid for by American consumers and taxpayers,” McDonald said.

George Yates of the Independent Petroleum Association of America, representing 5,000 crude oil and natural gas producers, commented, “It is the president’s responsibility to study this issue exhaustively before sacrificing thousands of jobs and spending billions in taxpayer dollars.” And the U.S. Chamber of Commerce stated that it “would not support any international global climate plan that is unfair to American business or results in substantial job losses, hidden taxes, or higher energy costs” (BNA Daily Environment Report, October 23, 1997).

Kevin Fay, executive director of the International Climate Change Partnership, an industry group who hopes to make money on emission trading, lamented the administration’s focus on targets and timetables. “It appears,” said Fay, “that the recent administration focus has been on the target and timetable [issue].” The “sensible, market-based frameworkis crumbling around us,” Fay said (BNA Daily Environment Report, October 22, 1997).

Foreign Reactions to U.S. Proposal

Dominique Voynet, French minister of environment and territorial development attacked the U.S. proposal as “a step backward” and “not up to the challenge at hand.” The European Union’s (EU) greenhouse gas reduction proposal “remains the only realistic starting point,” Voynet said. France has agreed to a 5 percent emissions reduction below 1990 levels by 2010 under the EU plan which calls for a 15 percent reduction for the EU as a unit (BNA Daily Environment Report, October 24, 1997).

Spokesman for the European Commission Peter Jorgensen said that the “U.S. is shirking its global responsibility to counter climate change.” The U.S., argued Jorgensen, is backtracking on the agreement it made in 1992 to reduce emissions to 1990 levels by 2000. According to Jorgensen, “it is totally inadequate and downright irresponsible” (BNA Daily Environment Report, October 23, 1997).

Regarding the U.S. position on developing nation participation the European Union’s Environment Commissioner Ritt Bjerregaard said, “We do not share the view as voiced by the U.S. that developing countries should also make cuts. The U.S. and other industrialized countries have a moral responsibility to make a commitment first. After we do that, then we can discuss the issue with developing countries” (BNA Daily Environment Report, October 20, 1997).

News from Bonn

As has become tradition at United Nations conferences the U.S., according to one source, “has come under extraordinary criticism” for its negotiating position. The biggest surprise to come from the Bonn conference is the newly proposed position of the G-77 developing countries. They are calling for a 35 percent reduction below 1990 levels by 2020.

More significantly, they are calling for the creation of a foreign aid fund to be financed by the industrialized countries. If the industrialized countries fail to meet their emission reduction targets the fund will be used to compensate the developing countries for the social, environmental and economic damage that might occur from climate change.

The G-77 has also made it clear that it will not accept a protocol that commits them to targets and timetables, nor a protocol that requires them to participate in joint implementation or emission trading schemes. It appears that negotiations are in total disarray.

Carbon Free Military?

President Clinton’s pledge to “lead by example” by requiring federal agencies to reduce greenhouse gas emissions has some national defense analysts alarmed. In a Wall Street

Journal (October 16, 1997) op-ed, Frank Gaffney of the Center for Security Policy warns that restrictions on fossil fuel use would cause serious damage to the readiness of U.S. military forces. According to a memo by Deputy Undersecretary of Defense for Environmental Security Sherri Goodman, a 10 percent reduction in military fuel use would result in “unacceptable impacts on national security.” Such a reduction would lead to the loss of 328,000 miles per year from tank training exercises for the Army, 2,000 steaming days per year from the Navy’s training and operations for deployed ships, and 210,000 flying hours per year for the Air Force, severely affecting the readiness of the armed forces.

Ms. Goodman’s memo proposes a “national security waiver” which “should address military tactical and strategic systems used in training to support readiness or in support of national security, humanitarian activities, peace keeping peace enforcement and United Nation’s actions.” Though the military could do without humanitarian, peace keeping and United Nation’s actions, the nation cannot do without a strong national defense.

Other International News

In response to demands from the European Union and the United States, Japan has agreed to revise its proposal from regulating three greenhouse gases, carbon dioxide, methane, and nitrous oxide, to six, adding hydrofluoroocarbons, perfluorocarbons, and sulfur hexafluoride. Japan will begin by regulating the first three gases and then after “a certain period” will take measure the reduce the other three gases (BNA Daily Environment Report, October 22, 1997).

The European branch of the Global Legislators for a Balanced Environment has threatened to organize a consumer boycott of American oil producers and automobile manufacturers is they succeed in preventing an agreement to reduce greenhouse gas emissions in Kyoto. The threat is in response to a television advertising campaign, sponsored by an industry coalition, which opposes an agreement to restrict energy use in the industrialized countries (BNA Daily Environment Report, October 20, 1997).

The European Union says that it is not prepared to act unilaterally on climate change. Jurgen Henningsen, director of the European Commission’s Environmental Directorate, said at a briefing that “We aren’t about to shoot ourselves in the foot and put our industries at a competitive disadvantage” (BNA Daily Environment Report, October 27, 1997). Of course, the EU proposal is designed to do just that to the other industrialized countries.